How to Get Out of Whole Life Insurance

Whole life insurance policies are long-term financial instruments designed to provide coverage for an individual’s entire life while also accumulating cash value. Over time, policyholders may find their financial circumstances or personal needs change, prompting them to re-evaluate their existing whole life coverage. Such changes could lead to a desire to modify or even terminate the policy.

This article explores the primary methods for altering or ending a whole life insurance policy. It also details the financial implications associated with each approach, guiding those considering adjustments to their life insurance arrangements.

Terminating Your Policy

Ending a whole life insurance policy involves several distinct methods, each with its own procedures and considerations. Policyholders can choose to actively cancel their policy, allow it to lapse, or sell it to a third party. Each option requires specific preparatory steps to ensure a smooth transition.

Surrendering a whole life policy means actively canceling it in exchange for its cash surrender value. To initiate this process, the policyholder contacts the insurance company to request the necessary surrender forms. These forms require information such as the policy number, personal identification, and instructions for how to disburse the funds. The cash surrender value is the amount received after any applicable fees or outstanding policy loans are deducted.

Allowing a policy to lapse occurs when premium payments are stopped. Insurance companies provide a grace period, often 30 to 60 days, during which the policy remains in force even if a premium is missed. If payment is not received, the policy may automatically use its accumulated cash value to cover premiums, a feature known as an automatic premium loan. If the cash value is insufficient, the policy will terminate, and coverage will cease.

Selling a whole life policy, known as a life settlement, involves transferring ownership to a third party for a cash payment. This payment is more than the policy’s cash surrender value but less than its death benefit. Life settlements are considered by older policyholders or those with declining health, as life expectancy influences the policy’s value to a buyer. A licensed life settlement broker helps present the policy to potential buyers, who conduct medical underwriting to assess the insured’s health. Policyholders should gather policy documents, including premium payment history and medical records, for evaluation.

Adjusting Your Policy

Instead of outright termination, policyholders can adjust a whole life policy to better suit changing financial situations or coverage needs. These adjustments aim to reduce the premium burden or modify the type of coverage while maintaining a relationship with the insurer. Each option involves specific steps to implement the change.

The Reduced Paid-Up option allows the policyholder to use existing cash value to purchase a smaller, fully paid-up whole life policy. No further premiums are due once this option is exercised, and the reduced death benefit is guaranteed for the remainder of the insured’s life. Policyholders contact their insurer to request an illustration of the reduced death benefit amount based on their current cash value and age. The decision to elect this option is irreversible, meaning future premium payments cannot be made to increase the death benefit.

The Extended Term option uses the policy’s cash value to purchase a term life policy for the original death benefit amount. This term policy remains in force for a specific period, after which coverage expires, and no further premiums are required. The length of the extended term depends on the accumulated cash value and the insured’s age. Policyholders should contact their insurance provider to determine the duration of coverage their cash value can support.

Accessing the policy’s cash value through loans or withdrawals can also help manage premium costs or provide liquidity. Policy loans allow the policyholder to borrow against the cash value, with interest accruing on the borrowed amount. If the loan is not repaid, it reduces the death benefit paid to beneficiaries. Withdrawals directly reduce the policy’s cash value and, consequently, the death benefit. These options can provide financial relief, potentially allowing policyholders to continue coverage without out-of-pocket premium payments.

A 1035 Exchange allows for a tax-free transfer of funds from one life insurance policy to another, or to an annuity, without triggering immediate taxation on any gains. This option is used to move from a whole life policy to a different type of insurance or to an annuity, if it better suits the policyholder’s evolving needs. The process requires direct transfer of funds between the old and new insurance companies to maintain its tax-deferred status. Policyholders must ensure the exchange adheres to Internal Revenue Code Section 1035 rules to avoid unintended tax consequences.

Understanding Financial and Tax Impacts

Terminating or adjusting a whole life insurance policy carries financial and tax implications that policyholders should consider. The outcomes vary depending on the chosen method, impacting the cash received, potential tax liabilities, and the remaining death benefit. This section details these consequences.

When surrendering a whole life policy, the cash surrender value (CSV) is calculated by taking the accumulated cash value—which grows from a portion of premiums paid plus interest or dividends—and then subtracting any surrender charges, outstanding policy loans, or unpaid premiums. Surrender charges, fees deducted for early termination, can reduce the payout, especially within the first 10 to 15 years of the policy. These charges decline over time, eventually disappearing after a certain number of years.

A taxable gain or loss can arise when surrendering a policy. If the amount received from the surrender exceeds the policyholder’s “cost basis,” the difference is considered taxable ordinary income. The cost basis for a life insurance policy is defined as the total premiums paid into the policy, minus any tax-free withdrawals or distributions previously taken. Losses incurred from surrendering a policy are not tax-deductible. For instance, if a policyholder paid $30,000 in premiums and received $45,000 upon surrender, the $15,000 difference would be taxed as ordinary income.

Any termination or adjustment of a policy will lead to a loss or reduction of the death benefit. Surrendering or lapsing a policy means the entire death benefit is forfeited, leaving no financial protection for beneficiaries. Options like Reduced Paid-Up or Extended Term allow for continued coverage, but the death benefit will be either permanently reduced or limited to a specific time frame.

Policy loans and withdrawals also have financial consequences. While loans allow access to cash value without immediate tax implications, interest accrues on the loan, and if unpaid, the loan amount reduces the death benefit. If a policy lapses with an outstanding loan, the loan amount exceeding the cost basis can become taxable income. Withdrawals directly reduce the cash value and the death benefit, and any amount withdrawn that exceeds the cost basis is subject to income tax.

Life settlements have a tax treatment. The proceeds are taxed in three tiers: the portion up to the policy’s cost basis is received tax-free. The amount between the cost basis and the policy’s cash surrender value is taxed as ordinary income. Any remaining proceeds above the cash surrender value are taxed as capital gains.

A properly executed 1035 exchange is tax-free, allowing for the deferral of taxes on investment gains. However, certain actions can make an exchange taxable. If cash is received by the policyholder during the exchange, or if an outstanding policy loan is not handled correctly, the transaction may lose its tax-deferred status, potentially triggering taxable income. Ensure that the exchange is a direct transfer between insurers and adheres to all IRS guidelines to avoid these pitfalls.